Long/short options ideas on European banks in June 2024

During the year to 3 June 2024, European shares in the financials sector, and the banking industry specifically, have managed to see their prices rise even more than stocks focused on “hotter” themes like artificial intelligence and weight loss drugs. Given the Swiss National Bank has already started rate cuts, and many eyes remain on the European Central Bank and US Federal Reserve to see if they’ll do the same, it is an interesting time to consider exposure to European banks. Options represent an attractive way to gain such exposures, with Cboe Europe Derivatives (CEDX) currently offering options on 14 bank stocks from across Europe.

In previous European stock market cycles, bank stocks, as measured by the EURO STOXX® Banks index, have tended to decline dramatically during downturns, most extremely by around 80% from May 2007 to March 2009, with 50% drawdowns also seen from 2000 to 2003, and 2011 to 2012, and again from 2018 to 2020. This asymmetric downside exposure in bank stocks can be explained by their leveraged business models: of the 14 bank stocks with options listed on Cboe Europe Derivatives (CEDX), most had a total equity to total assets ratio between 5-8%, meaning any decline in these banks’ asset values would be multiplied 12.5 – 20x in terms of net value to shareholders. For this reason, traders fearing or expecting a market pull back may find buying put options on bank stocks an effective way to capture such a decline.  

In this article, we consider two option strategies for traders looking to buy this type of downside exposure to a fictional bank stock, which we will call “Rhine Finance”, or “Rhine” for short. Advantages of putting on this long/short trade through option strategies like these, rather than by directly selling short shares of Rhine, include:

1.   Maximum loss on the short Rhine position can be strictly limited

2.   Borrow costs on the short position are locked in for the term of the trade, and

3.   No exposure to having borrowed shares called back by the securities lender

For simplicity, we will assume that Rhine is currently trading at exactly 100 per share, and no dividends are expected to be paid between now and option expiry.

Strategy #1: Buying an outright put option

The first strategy we will consider here is one where the trader simply buys a put option on Rhine. The two remaining choices the trader would need to make would be to decide on the expiry date and strike price of the option. For this example, we will consider a 3-month, 95 strike put option on Rhine, which if comparably priced to similar put options on European bank stocks in the market at the time of this writing, might be bought for around 2.50 points, or 250 per 100-share contract. When these options expire three months from now, one of the following three things can happen based on where Rhine shares close that day:

1.   If Rhine remains above the strike price of 95, the option expires worthless and the trader loses the 250 premium, or

2.   If Rhine falls only slightly below the strike price, say to 94, then the option would expire with a value less than that of the premium paid. In this case, the option would be worth 100 at expiry (=100 shares x (95 strike price – 94 final price of Rhine)), a significant but not total loss relative to the premium paid, or

3.   If Rhine falls significantly, say to 85, then the option would expire with a value significantly more than that of the premium paid. In this case, the option would be worth 1,000 at expiry (=100 shares x (95 strike price – 85 final price of Rhine)), several times the premium paid in this scenario.

The biggest advantage of this strategy is that it is very simple: a premium is paid in exchange for exposure to Rhine falling below the strike price by the expiry date, and that’s it. One disadvantage of this strategy, which many consider a disadvantage of buying many types of insurance, is that the premium is “lost” if Rhine does not fall. In the options market, this trader would see this option “time decay” in value every single day that Rhine does not fall, which may be a cost worth paying, but will be a reason many traders may look at other strategies to mitigate this cost.

Payout Table

Strategy #2: Buying a 1x2 put spread

There are many different option strategies that also provide the trader with profitable exposure to a decline in a stock, each with their own trade-offs. In this case, we will consider an option combination that preserves the exposure to a large downside move in Rhine shares while significantly reducing the up-front cost of the net option position. This combination has the trader selling one 3-month 100 strike put and buying two 3-month 95 strike puts. The latter is the same put option seen in Strategy #1, but by buying two of these, and partly financing these by selling the higher-strike put, the net up-front cost of this option position is reduced significantly. Again assuming Rhine options would price similarly to a few other European bank stock puts in early June 2024, we can assume the up-front cost of this option position would net to around 0.80 per share, or 80 per 100 share lot contract, about one-third that of the outright 95 strike put. This option position would then have the following results based on Rhine’s closing price at expiry:

1.   If Rhine finishes above 100, both options expire worthless, and the 80 premium is lost, or

2.   If Rhine finishes between 95 and 100, the 95 strike puts the trader bought expire worthless, but the 100 strike put sold has a net negative value of 1 per cent Rhine finishes below 100. For example, if Rhine finishes at 96.50, this option position will have a net negative value of 350 (=100 shares x (100 strike price – 96.50 final price of Rhine)), in addition to the loss of the 80 premium paid up front, or

3.   If Rhine finishes between 90 and 95, then the positive value of the two 95 strike puts purchased would partly offset the negative value of the one 100 strike put sold. For example, if Rhine finishes at 93.50, this option position will also have a net negative value of 350, which as in the example above is in addition to the loss of the 80 premium paid up front. This net negative value is the sum of the negative 650 value of the 100 strike put sold (=100 shares x (100 strike price – 93.50 final price of Rhine)), offset by the positive 300 value of the two 95 strike puts bought (=200 shares x (95 strike price – 93.50 final price of Rhine)), or

4.   If Rhine falls below 90, say to 85, then the positive value of the two 95 strike puts purchased would more than offset the negative value of the one 100 strike put sold. In this example, the assumed final Rhine price of 85 would result in a net final option value of 500, which is multiples of the 80 premium paid up front. This net negative value is the sum of the negative 1,500 value of the 100 strike put sold (=100 shares x (100 strike price – 85 final price of Rhine)), offset by the positive 2,000 value of the two 95 strike puts bought (=200 shares x (95 strike price – 85 final price of Rhine)).

This “1x2” combination of put options can be seen as a way of “paying more later” for the option in the scenario where Rhine falls only a little bit, in exchange for risking significantly less loss of premium in the event Rhine shares rise. The maximum loss of this strategy is 580, if the share price finishes at 95.

Payout Table

Conclusions

While buying outright put options may be the simplest way of buying limited risk payoffs in the case where a stock declines, these come with the risk of losing a significant amount of premium if that stock does not fall by enough to make up for the premium. Option combinations, like the 1x2 put combination highlighted in Strategy #2, are one way to move the cost of this downside exposure from a simple up-front certain payment to a larger contingent payment if the stock finishes in a range the trader does not expect it to finish within. The maximum loss of the “1x2” put combination is higher than the simple outright put option strategy.

Learn more

Visit Cboe’s Options Institute to explore the basics of options trading, here.

Cboe Europe offers trading in shares from across Europe and, through Cboe Europe Derivatives (CEDX), options are also available on shares in over 300 leading European companies.

Learn more about CEDX here.

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·      The above is the product of external market analysis commissioned on behalf of Cboe Europe B.V. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Europe B.V., Cboe Global Markets, Inc. or any of its affiliates (‘Cboe’). For more information on how this research was conducted and/or the author please contact [email protected]

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